The red-faced spluttering from parts of the City was an all-too-predictable response to Adair Turner's comments that he would consider tax measures to damp down excessive banking profits and pay.

But the outrage at the chairman of the Financial Services Authority having the temerity to float the idea of a Tobin tax - a small levy on financial transactions - obscured even more important elements of what he was saying. When Lord Turner suggested some of what the financial services sector does is socially useless, that the industry might be bigger than it ought to be, and that cheerleading for the City should not be a priority for regulators, he raised some absolutely fundamental questions.

What is the City for? What should it be doing, and at what price? How big should it be? What is good banking and what is bad banking? How can we stop the abuse of taxpayer support?

Stripping out all the complexities, the answer to the first question is that the function of financial services is to turn savings into investment, to channel capital to businesses that will make productive use of it. Financial services ought to be an unglamorous utility business, not a well-rewarded vortex sucking in far too many of the best graduates in the UK and the US.

Here, one in five Oxford graduates have been funnelled into the City despite the crunch, and a quarter of Harvard grads go into finance. Many could be doing something more useful to society - and probably more fulfilling to themselves - elsewhere. Controlling bonuses is an essential part of rebalancing the economy so other, more productive, sectors are not denuded of talent.

How big is too big? Hard to say, but our financial services industry has almost certainly grown to be larger than socially optimal: it accounts for just over 7% of GDP, making it one of the largest among leading nations. As it has grown, manufacturing has shrunk in the past 10 years from almost 20% of the economy to just over 13%. Whatever the numbers, the intellectual zeitgeist accorded more importance to the sector than it deserved: in a sane world, financial services in the UK would do well when the British economy did well, not the other way around.

One of the shocking aspects of the crunch has been the speed with which bonuses and profits have come back at certain institutions: to give just one example, Barclays is luring a team from JP Morgan with an offer of £30m in cash and shares, and senior executive Roger Jenkins, who is reputed to be on a pay and bonus package of £40m, is leaving to become a consultant, for reasons the bank claims have nothing to do with an attempt to keep his rewards out of the public domain.

Big bonuses are a consequence of big profits: both are excessive. With much of the competition taken out of the game, the likes of Barclays and Goldman Sachs stand to do even better than before: as one correspondent to the Financial Times put it, the wonder is that corporate customers continue to be willing to pay so much for "essentially commoditised services".

In order to separate "good banking" - providing sensibly priced products and services that benefit customers - from "bad banking" - speculative, high-priced activities that benefit bankers - there needs to be some version of the Glass-Steagall Act, the Depression-era legislation in the US that separated casino banking from the boring stuff, with only the latter entitled to taxpayer support. This idea is almost as repugnant to the banking industry - which lobbied hard for Glass-Steagall to be scrapped until President Clinton obliged in the 1990s - as a Tobin tax.

The City has a stock argument against proposals it doesn't like: that whatever it is would not work in isolation, so global agreement must be sought because going it alone would damage London as a financial centre. This is prelapsarian poppycock. The City of London has grown to its present stature over 300 years: it has the advantages of the English language, a convenient time zone and a cluster of professional services, not to mention institutions, such as Lloyd's of London, that have not disgraced themselves. If we were to take a lead on post-crunch reform, there is a chance it would stiffen spines abroad, and in reality there is little fear of tumbleweed and boarded-up windows in the Square Mile.

In the run up to the G20 meetings, the government, which seems to have lost its appetite for taking on the City, should reflect that the UK and the US have a duty to put themselves in the vanguard of reform. We led the world into ultra-liberalism and sub-prime mayhem. The least we can do is try to lead it back out again.